Bank Reserves

What It Means

The money that a bank keeps on hand, either in its own vaults or in an account with a central bank, is referred to as the bank’s reserves. Not all the money that is deposited in a bank stays there. When an individual deposits money in a bank, the bank uses most of that money to make loans, and the bank charges interest (a fee people must pay to borrow money) on those loans. Because interest payments account for much of a bank’s profits, it is natural for them to want to loan out as much of the money deposited with them as possible. They must balance this desire for profit, however, with the demands of depositors (bank account holders); that is, when depositors want to withdraw money from their accounts, the bank must have the money on hand to give them.

To ensure the stability of the banking system, most countries today require banks to keep a certain amount of money in reserve at all times. Usually this amount of money, called required reserves, is defined as a percentage of the amount of money that the bank takes in through deposits. For instance, say that the U.S. government requires banks to maintain reserves equal to 10 percent of their deposits. If a bank takes in $1,000,000 in deposits, it would be obliged to keep $100,000 in its vaults or in its account with the central bank of the United States (called the Federal Reserve System, or the Fed, an independent agency of the U.S. government). Any money beyond this required amount is called excess reserves and can be used to make loans.

Required reserves represent money that is simply being stored, whereas loans represent money that is being used to generate more money. When banks loan money, the people and businesses that borrow it are able to make a wide range of purchases they could not otherwise make, and the economy grows. Therefore, the proportion of money that banks are required to set aside as reserves has a dramatic effect on the overall economy.

When Did It Begin

During the medieval period in Europe (about 500–1500 ad ), gold was the dominant form of money. Gold is heavy and cumbersome to move, and in many communities goldsmiths (who, because they worked with gold, were capable of judging its purity, weighing it accurately, and storing it) became the keepers of gold. An individual would take his gold to the goldsmith’s place of business for safe-keeping, and the goldsmith would give him a receipt stating how much gold he had deposited. Over time people recognized that the goldsmith’s receipts themselves had value, because they were stand-ins for the amount of gold indicated. Rather than retrieve gold in order to make everyday purchases, people began using the goldsmiths’ receipts as money.

At some point it became clear to goldsmiths that there was rarely a situation in which a majority of depositors wanted their gold at the same time. Instead, people preferred to use the much more convenient receipts, confident that these could be exchanged for gold whenever necessary. The goldsmiths, realizing that they could generate more profits for themselves by making loans, began to issue receipts to people who wanted to borrow money. In this way they were creating more money than actually existed in the form of gold. They made loans in proportion to the amount of gold they had in reserve, balancing their desire for profit against the need to be prepared when depositors showed up wishing to make withdrawals.

These goldsmiths created the concept of fractional-reserve banking (when banks reserve, or set aside, only a small portion of their deposits and loan or invest the rest in order to make a profit), the cornerstone of the modern banking system. The gold reserves of medieval Europe were the predecessors of what we now call bank reserves.

More Detailed Information

The modern banking system is directly descended from the system created by medieval European goldsmiths, with government-issued bills and coins replacing gold in the scenario described above. Banks today issue far more money (by giving loans in the form of checks and checking accounts rather than in cash) than actually exists in the form of government-issued bills and coins.

This money-creating function of banks is not only essential to the business success of the banks themselves, but it is also the foundation of all economic activity in capitalist countries (countries in which businesses are owned largely by private individuals, not the government). If the money supply (the amount of money circulating in a country’s economy) were limited strictly to bills and coins, modern economies would be far smaller and less dynamic than they are. This is because the creation of money does not stop with each individual loan.

Consider the following simplified illustration of how fractional-reserve banking works. John Doe deposits $10,000 in cash at Bank A. Bank A, wanting to make as much profit as possible, sets aside only the amount of money required by law. Assuming for simplicity’s sake that the government currently requires banks to reserve 10 percent of their deposits, Bank A would reserve $1,000 and then look for a loan applicant.

At this point Jane Smith walks through the doors of Bank A and applies for a $9,000 loan to start a pizza parlor. Bank A gives her a checking account that has a balance (a credit) of $9,000, along with a book of checks, and Jane begins shopping for equipment and supplies. Say that Jane is able to get all of her start-up needs taken care of at Pizza Suppliers, Inc., and she writes them a $9,000 check. Pizza Suppliers, Inc. will deposit Jane’s check at Bank B, where the business has an account.

Bank B, after setting aside 10 percent ($900) of this deposit amount, will loan out the remaining $8,100. This loan will generate more check writing, more bank deposits, and more loans. It will create more and more money that previously did not exist, until the money-creating potential of John Doe’s original $10,000 is exhausted.

Because bank deposits have, in this way, tremendous ripple effects, changes in the amount of bank reserves required by law have a powerful influence on the economy. Increases in the required reserve amount mean more money taken out of circulation at every stage of the process outlined above. Decreases in bank reserve requirements, however, represent additional money created at every stage.

Recent Trends

The money supply is one of the financial factors that most influences a country’s economy. When more money is in circulation, interest rates tend to fall, loaning activity increases, and the economy expands. When the money supply decreases, interest rates tend to rise, fewer people take out loans, and the economy contracts.

Today the Federal Reserve System attempts to regulate the U.S. economy by changing the quantity of money in circulation at any given time. The Fed does this not by ordering changes in the amount of money minted by the government but instead by influencing banks’ lending activities. Banks create money when they make loans, and they can make loans in proportion to the size of their cash reserves. When the Fed wants to influence banks to create more or less money, it uses certain tactics that change the levels of required bank reserves nationwide.